The Federal Reserve is slated to release its 2023 stress-testing results on Wednesday, June 28. Stress testing is a big deal for the largest and most complex banks in the country because it helps determine how much regulatory capital banks must hold and, therefore, how much excess capital banks have to return to shareholders.
After everything that has happened in the banking sector this year, investors and bank management teams are paying close attention to this year's results but are also not exactly sure what to expect, either.
While anything could happen, Fed stress-test results could end up turning into a big catalyst for Citigroup (C -0.64%) if the results come in better than expected. Let me explain.
How stress testing impacts capital ratios
Banks are subject to regulatory capital requirements. The goal is to ensure that banks can withstand unexpected losses and still lend to individuals, families, and businesses during a difficult economic environment.
While banks are subject to many regulatory capital ratios, a big one is the common equity tier 1 (CET1) capital ratio, which looks at a bank's core capital expressed as a percentage of its risk-weighted assets (RWA), such as loans. Each year, the largest banks get a new CET1 requirement, a big part of which is determined by stress testing.
Image source: Federal Reserve.
As you can see in the chart above, the CET1 ratio has three components. There's the 4.5% base layer that is required of all banks. The top layer is a special surcharge to the eight global systemically important banks (GSIB) that have been deemed "too big to fail." And then the middle layer is the stress capital buffer (SCB), which is determined by stress-testing results plus four quarters of dividends.
Stress testing puts banks through a hypothetical adverse economic scenario over a nine-quarter period to see how their balance sheets would fare and try to ensure the global banking system is safe and sound.
This year's stress-test scenario has unemployment rising from 3.5% to 10%, while commercial real estate prices are expected to fall by 40%. It also includes an exploratory market shock for the trading operations of GSIB banks, but those results will not impact capital requirements this year. The difference between the starting CET1 and the low point of a bank's CET1 ratio during the simulation, plus four quarters of dividends, determines a bank's SCB.
Where Citigroup stands
It's been a long slog for Citigroup since the Great Recession. After years of underperformance, the bank promoted Jane Fraser to CEO in early 2021.
Fraser wasted no time, embarking on an ambitious transformation plan that involved exiting its international consumer banking franchises and investing in higher-returning businesses like wealth management and investment banking. The bank also has regulatory issues to correct and, as a result, has seen expenses surge.
While some investors seem to like Fraser's plan, the bank has had to pause share repurchases several times over the last few years. Investors want Citigroup to be repurchasing as much stock as possible right now, with Citigroup trading around 56% of its tangible book value (TBV) or net worth. Share repurchases done below TBV end up growing TBV per share, which bank stocks trade relative to, so they can be very valuable long-term when conducted at this level.
However, Citigroup has been dealing with a number of moving parts, including the winding down of its international consumer banking franchises. Like most banks, Citigroup is also potentially looking at higher regulatory requirements, whether it's from stress-test results or other regulatory capital changes expected this year.
Citigroup's current SCB requirement is 4%, and its total CET1 requirement is 11.5%. But because of the uncertainty and complications with the sale of select operations in its Mexico franchise, Citibanamex, which is now no longer happening (the unit will eventually be spun out into an IPO), Citigroup has built a tremendous amount of excess capital. Its CET1 ratio increased from roughly 11.4% in the first quarter of 2022 to 13.4% at the end of the first quarter of this year. This may not sound like a lot, but it means that Citigroup has built billions of dollars of capital and also lowered its RWA.
How stress testing would turn into a catalyst
There's no doubt that Citigroup currently has a lot of excess capital, but after the banking crisis, investors and bank management teams seem unsure how severe the Fed might be in its stress-test modeling. Then they have to see what other changes are coming this year and also prepare for a more difficult economy, which means higher loan losses and higher reserves, which impact regulatory capital.
While stress-testing results could come in more severe than expected and lead to higher SCBs, if Citigroup's SCB remains at 4% and other regulations are manageable, the bank's required CET1 ratio may not rise too much, leaving Citigroup with excess capital.
For instance, even if Citigroup's CET1 requirement rises from 11.5% to 12.5%, the bank would likely be able to launch a meaningful buyback. When Citigroup announced it would no longer sell Citibanamex, it did restart a modest amount of share repurchases. But a 12.5% requirement would leave Citigroup with something like $10 billion of excess capital, by my calculations, which, along with the bank's earnings power, would set the stage for a material repurchase, which should catch the market's attention.
